A Plot Complication in the Semiconductor Story
In literature and script writing, a plot complication is a new element added to make the story more interesting and engaging as it moves from the introduction to the resolution.
For the semiconductor (“microchip,” or simply “chip”) industry, the story was supposed to be a straightforward one: expansive growth as the world becomes digitized. Chip companies were supposed to evolve to become high-margin chip designers, leaving the capital-intensive and extremely complicated manufacturing to specialists like Taiwan Semiconductor. The vast majority of chip companies have followed this script and don’t produce their own chips.
Intel’s recently publicized struggles with its own chip production highlight the trajectory of this story. The company has been unable to successfully transition to leading-edge manufacturing technologies, and is seriously considering outsourcing to companies like Taiwan Semiconductor. Intel has long been the industry’s torch-bearer in chip self-reliance – with a strong aversion to using third party producers – so its change in mindset is a watershed event.
However, on the way to an outsourced future with boundless growth, the plot has become more complicated. Semiconductors are critical components of all tech-related products, and increasingly all aspects of daily life. With more production concentrated into fewer hands, near-term supply shortages have emerged, as accelerated demand is meeting Covid-related production slowdowns. Tight supplies mean some customers don’t get the chips they need. Low-margin chips used by car manufacturers like Honda, Volkswagen and General Motors tend to be low priority, leading to delays at some car/truck production facilities.
More critically, with Taiwan Semiconductor at the vanguard in terms of technology prowess and sheer volume, the Western chip industry is increasingly exposed to China’s ambitions. China has only a fledgling domestic chip industry, so it also relies, uncomfortably, on the island’s output. It is no secret that mainland China views Taiwan as part of its sovereign territory, and in recent weeks has stepped up its military fly-bys and cyberattacks on Taiwan. Western government officials, including those in the United States, have voiced enough concern to begin accelerating their plans to boost their country’s domestic chip output.
This plot complication, which has converted chip production into a “strategic asset,” will increasingly affect semiconductor company strategy and may change investor perceptions. Intel, for example, could receive federal funds to help build domestic factories (fabs). Taiwan Semiconductor is exploring building a fab in Arizona and Samsung is considering a Texas fab. Other new fabs in Europe and Japan are apparently in the works, as well.
It is too early to know whether all of this will result in higher chip prices (from a heightened urgency to lock in long-term supply) or lower chip prices (due to the expansion in production capacity). We’ll have to wait for the next chapter to find out. But, clearly, the intensifying focus on chip production is making the story more interesting and engaging.
Share prices in the table reflect Tuesday (January 26) closing prices. Please note that prices in the discussion below are based on mid-day January 26 prices.
Note to new subscribers: You can find additional color on each recommendation, their recent earnings and other related news in prior editions of the Cabot Undervalued Stocks Advisor on the Cabot website.
Send questions and comments to Bruce@CabotWealth.com.
UPCOMING EARNINGS RELEASES
January 28: Dow, Inc. (DOW)
January 28: JetBlue (JBLU)
February 4: Merck (MRK)
February 4: Bristol-Myers (BMY)
February 4: Columbia Sportswear (COLM)
THIS WEEK’S PORTFOLIO CHANGES
Viacom (VIAC) – raising price target from 48 to 54.
LAST WEEK’S PORTFOLIO CHANGES (January 20 letter)
General Motors (GM) – raising price target from 49 to 62.
GROWTH/INCOME PORTFOLIO
Bristol-Myers Squibb Company (BMY) is a New York-based global biopharmaceutical company. In November 2019, the company acquired Celgene for a total value of $80.3 billion. We are looking for Bristol-Myers to return to overall revenue growth, both from resilience in their key franchises (Opdivo, Revlimid and Eliquis) and from new products currently in their pipeline. We also want to see the company execute on its $2.5 billion cost-cutting program which will likely remain intact with the MyoKardia acquisition.
There was no meaningful news on the company this past week.
BMY shares fell 2% in the past week and have about 19% upside to our 78 price target.
The stock trades at a low 8.8x estimated 2021 earnings of $7.44 (down a cent from last week). Bristol’s fundamental strength, low valuation and 3.0% dividend yield that is well-covered by enormous free cash flow makes a compelling story. STRONG BUY.
Cisco Systems (CSCO) generated about 72% of its $48 billion in revenues from equipment sales, including gear that connects and manages data and communications networks. Other revenues are generated from application software, security software and related services, providing customers a valuable one-stop-shop. Cisco is shifting toward a software and subscription model and ramping new products, helped by its strong reputation and its entrenched position within its customers’ infrastructure.
The emergence of cloud computing has reduced the need for Cisco’s gear, leading to a stagnant/depressed share price. Cisco’s prospects are starting to improve under CEO Chuck Robbins (since 2015). The company is highly profitable, generates vast cash flow (which it returns to shareholders through dividends and buybacks) and carries $30 billion in cash, double the $14.6 billion in total debt.
There was no meaningful news on the company this past week.
CSCO shares slipped 1% in the past week and have about 22% upside to our 55 price target. The shares trade at a low 14.2x estimated FY2021 earnings of $3.17. This estimate (along with the FY2022 estimate) ticked up a cent in the past week. On an EV/EBITDA basis on FY2021 estimates, the shares trade at a discounted 9.8x multiple. CSCO shares offer a 3.2% dividend yield. BUY.
Coca-Cola (KO) is best-known for its iconic soft drinks but nearly 40% of its revenues come from non-soda brands across the non-alcoholic spectrum, including PowerAde, Fuze Tea, Glaceau, Dasani, Minute Maid and Schweppes. Its vast global distribution system offers it the capability of reaching essentially every human on the planet.
While near-term outlook is clouded by pandemic-related stay-at-home restrictions, secular trends away from sugary sodas, high exposure to foreign currencies (now perhaps a positive) and always-aggressive competition, Coca-Cola’s longer-term picture looks bright. Relatively new CEO James Quincey (2017), a highly regarded company veteran with a track record of producing profit growth and making successful acquisitions, is reinvigorating the company by narrowing its oversized brand portfolio, boosting its innovation and improving its efficiency. The company is also working to improve its image (and reality) of selling sugar-intensive beverages that are packaged in environmentally insensitive plastic. Coca-Cola is supported by over $21 billion in cash which offsets much of its $53 billion in debt. Its growth investing, debt service and $0.41/share quarterly dividend are well-covered by free cash flow.
There was no meaningful news on the company this past week.
KO shares rose 1% in the past week, reversing weeks of slippage following downgrades from several brokerage firms. The stock has about 30% upside to our 64 price target. While the valuation is not statistically cheap, at 23.4x estimated 2021 earnings of $2.10 and 21.4x estimated 2022 earnings of $2.29 (both estimates unchanged in the past week), the shares are undervalued while also offering an attractive 3.3% dividend yield. BUY.
Dow Inc. (DOW) merged with DuPont in 2017 to temporarily create DowDuPont, then split into three companies in 2019 based roughly along product lines. The new Dow is the world’s largest producer of ethylene/polyethylene, the world’s most widely used plastics. Dow is primarily a cash-flow story driven by three forces: 1) petrochemical prices, which are often correlated with oil prices and global growth, along with competitors’ production volumes; 2) volume sold, largely driven by global economic conditions, and 3) ongoing efficiency improvements (a never-ending quest of all commodity companies to maintain their margins).
Dow reports earnings on Thursday. The consensus earnings estimate is $0.67/share.
Dow shares were unchanged this past week and have 5% upside to our 60 price target. Without any additional positive news, we are reluctant to increase our price target, yet we’re also reluctant to sell too soon in this strong market. The shares trade at 16.9x estimated 2022 earnings of $3.39, although these earnings are two years away. This estimate ticked up about 3% for the second consecutive week.
The high 4.9% dividend yield is particularly appealing for income-oriented investors. Dow currently is more than covering its dividend and management makes a convincing case that it will be sustained. However, there is a small risk of a cut if the economic and commodity recoveries unravel. HOLD.
Merck (MRK) – Pharmaceutical maker Merck focuses on oncology, vaccines, antibiotics and animal health. Keytruda, a blockbuster oncology treatment representing about 30% of total revenues, holds an impressive franchise that is growing at a 20+% annual rate.
To tighten its focus, Merck will spin off its Women’s Health business, along with its biosimilars and various legacy brands, by mid-year 2021. These businesses currently generate roughly 15% of Merck’s total revenues yet comprise half of its product roster. Merck also recently divested its stake in vaccine maker Moderna. Given the high valuations of other animal health businesses like Elanco and Zoetis, we would not be surprised to see Merck spin off or divest its animal health business. Merck has a solid balance sheet and is highly profitable.
Primary risks include its dependence on the Keytruda franchise, possible generic competition for its Januvia diabetes treatment starting in 2022, and the possibility of government price controls.
Merck terminated its Covid vaccine program, as the trials of its two primary in-development treatments produced disappointing results. The company will still attempt to develop two other experimental Covid drugs. Merck’s failure highlights some internal mis-steps as well as the difficulty in creating effective Covid vaccines.
Merck shares slipped 4% this past week and have about 31% upside to our 105 price target. Valuation is an attractive 12.7x this year’s estimated earnings of $6.31 (estimate unchanged this past week). The 3.2% dividend yield offers additional income-oriented investors. Merck produces generous free cash flow to fund this dividend as well as likely future dividend increases. BUY
Tyson Foods (TSN) is one of the world’s largest food companies, with over $42 billion in revenues last year. Beef products generate about 36% of total revenues, while chicken (31%), pork (10%), and prepared/other contribute the remaining revenues. It has the #1 domestic position in beef and chicken with roughly 21% market share in each. Its well-known brands include Tyson, Jimmy Dean, Hillshire Farms, Ball Park, Wright and Aidells. Tyson’s long-term growth strategy is to participate in the growing global demand for protein. The company has more work to do to convince investors that its future is brighter, particularly as it is more of a commodity company (and hence has lower margins) compared to its food processor peers.
Tyson recently raised its dividend by 6% to $0.445 per quarter. Tyson’s recovery will remain volatile from quarter to quarter but is on the right track.
The company agreed to pay $222 million to three groups of end-buyer plaintiffs to settle charges in the price-fixing scandal. TSN shares lifted about 4% on the news. Tyson still faces lawsuits from Walmart, Chick-fil-A, Kroger and others. We estimate that settlements for these could be another $300 million to $400 million. For perspective, a $350 million settlement would be around 1.4% of TSN’s $24.5 billion market value.
The stock rose 2% in the past week and has about 14% upside to our 75 price target. Valuation is attractive at 11.6x estimated 2021 earnings of $5.69. This estimate slipped two cents this past week, although the 2022 estimate (of $6.38) was 3 cents higher than a week ago. Currently the stock offers a 2.7% dividend yield. BUY.
U.S. Bancorp (USB), with a $70 billion market value, is the one of the largest banks in the country. It focuses is on consumer and commercial banking through its 2,730 branches in the midwest, southwest and western United States. It also offers a range of wealth management and payments services. Unlike majors JP Morgan, Bank of America and Goldman Sachs, U.S. Bancorp has essentially no investment banking or trading operations.
USB shares remain out of favor due to worries about a potential surge in pandemic-driven credit losses and weaker earnings due to the low interest rate environment.
However, U.S. Bancorp is one of the best-run banks in the country. Long known for conservative lending, its non-performing assets are only 0.41% of its total assets, lower than most peers and only modestly higher than a year ago. Also, unlike the prior cycle, home mortgage lending today is a source of credit strength. U.S. Bancorp has a solid capital base, bolstered by its sizeable credit loss reserves of over 2.6% of total loans. The bank maintains one of the best expense control ratios in the industry.
The bank reported fourth quarter earnings of $0.95/share, one cent above the consensus estimate. However, the shares fell 5% on the news, as investors expected more encouraging near-term results (consensus estimates don’t always fully reflect the market’s expectations). Buy-side investors and traders anticipated a faster recovery in U.S. Bancorp’s metrics, including a return to revenue, loan and profit growth. These improvements will arrive, but not just yet, hence the “disappointment.”
This aside, U.S. Bancorp’s results showed the bank’s enduring strength. Its return on assets was 1.10% and its return on equity of 12.1%, both above the rule-of-thumb benchmarks (1% for ROA and 10% for ROE). Its capital ratio of 9.7% remains healthy, particularly as the bank has reserves for credit losses of 2.7% of total loans, which provide an incremental loss buffer beyond its excess capital level. Credit quality remains strong.
The shares fell about 6% in the past week and have about 28% upside to our 58 price target. Most bank shares have fared similarly in the past week or so, for much the same reason as USB shares.
Valuation is a modest 10.8x estimated 2022 earnings of $4.21. This estimate rose about 3 cents this past week. On a price/tangible book value basis, USB shares trade at a reasonable 1.8x multiple of the $24.85 tangible book value. This ratio ignores the value of its payments, investment management and other service businesses that have low tangible book values but produce steady and strong earnings. Currently the stock offers an appealing 3.7% dividend yield. BUY.
BUY LOW OPPORTUNITIES PORTFOLIO
Columbia Sportswear (COLM) produces the highly recognizable Columbia brand outdoor and active lifestyle apparel and accessories, as well as SOREL, Mountain Hardware, and prAna products. For decades, the company was successfully led by the one-of-a-kind Gert Boyle, who passed away late last year. The Boyle family retains a 36% ownership stake and Gert’s son Timothy Boyle remains at the helm.
After a disappointing third quarter, after which the stock fell sharply, as price-sensitive investors we raised COLM shares back to a Buy. We think the company low-balled its guidance, with its long-term earnings power impeded but pushed out into the future. It also announced personnel changes in several key operational roles. Columbia’s balance sheet remained solid.
Columbia hired a senior Nike executive to run its U.S. sales group. This is another in a series of personnel moves at Columbia. Earlier this year a top Starbucks executive was added to Columbia’s board of directors, the chief operating officer stepped down (no replacement yet), the senior Americas manager was installed as the full-time head of omni-channel (a new position) and the chief digital officer role was created. Other executives received title promotions yet their roles remain the same. This shake-up suggests that the third quarter blunder had deeper roots and that the company is actively working to get back on the right track.
Columbia’s shares slipped about 3% this past week and have about 11% upside to our 100 price target. Valuation is 24.6x estimated 2021 earnings of $3.67 (estimate unchanged from last week). On 2022 estimated earnings of $4.64 (unchanged), the valuation is a more reasonable 19.5x. For comparison, the company earned $4.83/share in 2019. We recently moved the shares to a Hold as they are approaching our 100 price target. HOLD.
Equitable Holdings (EQH) owns two principal businesses: Equitable Financial Life Insurance Co. and a majority (65%) stake in AllianceBernstein Holdings L.P. (AB), a highly respected investment management and research firm. Equitable was spun-off from former French insurance parent AXA in 2018, although AXA still owns just under 10% of Equitable. With its newfound independence, Equitable is free to pursue new opportunities.
We recently moved EQH shares to a Sell, as they essentially reached our 28 price target. From here, the risk/reward appears unfavorable. We don’t see any particular fundamental issues at Equitable, and the 2.5% yield continues to offer some appeal. EQH shares rose 16% since the original recommendation and 43% since the CUSA analyst change at the end of June. SELL.
General Motors (GM) under CEO Mary Barra (since 2014) has transformed from a lumbering giant to a well-run and (almost) respected auto maker. The company has smartly exited many chronically unprofitable geographies (notably Europe) and trimmed its passenger car roster while boosting its North American market share with increasingly competitive vehicles, particularly light trucks. We consider its electric and autonomous vehicle efforts to be near industry-leading. We would say it is perhaps 75% of the way through its gas-powered vehicle turnaround, and is well-positioned but in the very early stages of its EV development. GM’s balance sheet is sturdy, with Automotive segment cash exceeding Automotive debt. Its credit operations are well-capitalized but may yet be tested as the pandemic unfolds.
President Biden vowed to replace the U.S. Government’s fleet of 650,000 vehicles with American-made electric vehicles. While the idea makes great headlines and would be a huge boost to GM (along with Ford, Tesla and Chrysler), we see its execution as unlikely and slow. The price tag of perhaps $33 billion (assuming just over $50,000/vehicle) is enormous even in an era when trillions of dollars are tossed around like nickels. It’s not clear if this volume of EVs could even be produced or how they would be recharged and maintained.
One emerging near-term risk (and perhaps mid-term risk as well) is the growing shortage of semiconductor chips. Surging global demand and Covid-induced output reductions are behind the shortage. Many car makers, including GM, Volkswagen, Chrysler, Honda and others, have trimmed their production volumes due to shortages. See our opening comments in this letter for more on this intriguing issue.
GM shares rose 5% in the past week, although this masks a sharp 34% surge to its YTD high of 55.86 on January 20, followed by a 6% pullback since then. Some slippage should be expected – the shares reached an all-time high after languishing for over a decade after their November 2010 IPO at 33. Many investors are probably cashing out after a long wait. We see fair value at 62, so the shares have about 18% upside to our target price.
On a P/E basis, the shares trade at 8.7x estimated calendar 2021 earnings of $6.03 (up about four cents this past week).
Last week we raised our price target on GM to 62 from 49. Please see last week’s opening note for more commentary. HOLD.
JetBlue Airlines (JBLU) is a low-cost airlines company. Started in 1999, the company serves nearly 100 destinations in the United States, the Caribbean and Latin America. The company’s revenues of $8.1 billion in 2019 compared to about $45 billion for legacy carriers like United, American and Delta, and were about a third of Southwest Airlines ($22 billion). Its low fares and high customer service ratings have built strong brand loyalty, while low costs have helped JetBlue produce high margins. Its TrueBlue mileage awards program, which sells miles to credit card issuers, is a recurring source of profits.
We believe consumers (and eventually business travelers) are likely to return to flying. JetBlue has aggressively cut its cash outflow to endure through the downturn. Although its $4.8 billion debt is elevated, its $3.6 billion cash balance gives the airline plenty of time to recover. JBLU shares carry more than the typical CUSA stock.
JetBlue reports earnings on Thursday. The consensus estimate is for a loss of $(1.66)/share. More important than earnings will be commentary about their monthly cash burn rate, seat volumes and ticket prices, as well as management’s outlook including their January trends. Separately, JetBlue received a $206 million payroll support grant from the U.S. government which does not have to be repaid.
JBLU shares fell 1% this past week and have 28% upside to our 19 price target. The stock trades at 13.6x estimated 2022 earnings of $1.09 (this estimate rose a cent over the past week and is volatile based on Covid case trends). Interestingly, the 2021 estimated loss per share continues to widen, now at $(1.25) as near-term Covid case trends have pushed a recovery out a quarter or more. On an EV/EBITDA basis, the shares trade at 5.5x estimated 2022 EBITDA. BUY.
Molson Coors Beverage Company (TAP) – The thesis for this company is straight-forward – a reasonably stable company whose shares sell at an overly discounted price. One of the world’s largest beverage companies, Molson Coors produces the highly recognized Coors, Molson, Miller and Blue Moon brands as well as numerous local, craft and specialty beers. About two-thirds of its $10 billion in net revenues are produced in the United States, where it holds a 24% share of the beer market.
Investors’ primary worry about Molson Coors is its lack of meaningful (or any) revenue growth as produces relatively few of the fast-growing hard seltzers and other trendier beverages. Our view is that the company’s revenues are resilient, it produces generous cash flow and is reducing its debt, traits that are value-accretive and underpriced by the market. A new CEO is helping improve its operating efficiency and expand carefully into more growthier products.
We anticipate that the company will resume paying a dividend mid-year, perhaps at a $0.35/share quarterly rate, which would provide a generous 2.7% yield.
MolsonCoors announced a partnership to distribute Superbird, a premium ready-to-drink tequila-based cocktail. It is the company’s first move into the premium RTD category and suggests incremental progress toward its expansion efforts.
TAP shares slipped 1% in the past week and have about 13% upside to our 59 price target.
Estimates were flat/down this past week. TAP shares trade at 12.4x estimated 2021 earnings of $4.21. This valuation is low, although not the stunning bargain from a few months ago.
On an EV/EBITDA basis, or enterprise value/cash operating profits, the shares trade for about 8.7 current year estimates, among the lowest valuations in the consumer staples group and well below other brewing companies.
For investors looking for a stable company trading at a low valuation, TAP shares continue to have contrarian appeal. Patience is the key with Molson Coors. We think the value is solid although it might take a year or two to be fully recognized by the market. BUY.
Terminix Global Holdings (TMX) is both a new company and an old company. While the name “Terminix” is one of the largest and most widely recognized names in pest control, the company previously was obscured inside of the ServiceMaster conglomerate. With the sale of ServiceMaster Brands, the company changed its name to Terminix. The company appears to have fully addressed its legal liability from deficient termite treatments, removing an overhang on its shares.
A new CEO, Brett Ponton, former head of Monro (MNRO), joined in August 2020. His leadership at Monro led to sales growth and a strong recovery in its share price. Our expectation is that he will bring sales growth, operational efficiency and integrity to Terminix, ultimately leading to a higher share price. The company’s balance sheet is in good condition. Major risks include the possibility of higher litigation expenses, strong competition, and possible execution risks by the new leadership. TMX shares carry more risk than typical CUSA stocks.
There was no meaningful news on the company this past week.
Terminix shares slipped about 6% in the past week and have 17% remaining upside to our 57 price target.
Reliable consensus 2022 earnings estimates appear to be settling at around $1.43/share. This would put the TMX multiple at a high 34.1x, but we recognize that these types of companies generally are valued on EV/EBITDA. On this basis, the shares trade at about 18.5x EBITDA.
We recently moved the shares to a HOLD as they approached our price target. HOLD.
ViacomCBS (VIAC) is a major media and entertainment company, owning highly recognized properties including Nickelodeon, Comedy Central, MTV and BET, the Paramount movie studios, Showtime and all of the CBS-related media assets. The company’s brands are powerful and enduring, typically holding the #1 market shares in the highest-valued demographic groups in the country. ViacomCBS’s reach extends into 180 countries around the world. Viacom and CBS re-merged in late 2019 and are now under the capable leadership of former Viacom CEO Robert Bakish.
Viacom is being overhauled to stabilize its revenues, boost its relevancy for current/future viewing habits and improve its free cash flow. The company is shifting away from advertising (currently about 36% of revenues) and affiliate fees (currently about 39% of revenues), toward content licensing – essentially renting its vast library of movies, TV shows and other content to third-party firms like Netflix and others. Viacom is building out its own streaming channel (Paramount+) and other new distribution channels, which are generally showing fast growth. Ultimately, we think the company may be acquired by a major competitor, given its valuable businesses and content library, as well as its bite-sized market cap of about $20 billion.
Its challenges include the steady secular shift away from cable TV subscriptions, which is pressuring advertising and subscription revenues. The pandemic-related reductions in major sporting events are also weighing on VIAC shares. However, ViacomCBS’s extensive reach, strong market position and strategic value to other, much larger media companies, and its low share valuation, make the stock appealing.
There was no meaningful news on the company this week.
VIAC shares lifted another 11% this past week and have gained 33% so far this year. Much of the run-up is due to enthusiasm over Viacom’s streaming service as well as perhaps recognition of its low valuation and the likelihood of a return to more advertising as the economy opens up. We are raising our price target to 54 to incorporate what appears to be higher earning power than we initially expected. VIAC shares have about 8% upside to this new target.
Valuation is currently at about 9.4x estimated 2022 EBITDA, which we believe undervalues the company’s impressive leadership and assets. On a price/earnings basis, VIAC shares trade at 10.9x estimated 2021 earnings of $4.61. ViacomCBS shares offer a sustainable 1.9% dividend yield and look attractive here. BUY
